The terms “futures and options” are often used together in the same sentence, especially when referring to foreign exchange (forex). While usually referred to in unison, they are actually two different and distinct types of financial instruments. To understand both, one must first take a step back and understand that these instruments can both be classified as derivatives.1
What Is A Derivative?
A derivative is a financial contract between two or more parties, whose value is determined from the value of another underlying asset. Derivatives come in a variety of types, the two most common being futures and options. These instruments are often used to mitigate the risk that one of the parties in the contract seeks to hedge against, while allowing the other party in the contract the opportunity to gain a higher return on their investment in the contract. With higher risks come higher gains, and mitigating risks (by contracting them away to the other party) comes at a cost.2
What Is a Futures Contract?
Futures are contracts that give buyers the obligation to buy an asset or commodity, and the seller the obligation to sell that asset or commodity, at an agreed upon price at a future point in time. Because this agreement is binding and not simply an option to buy or sell the underlying asset, futures are justly called futures contracts. Futures contracts are traded on a broad variety of underlying assets, including commodities such as grain, gold, silver, electricity production, crude oil, beef, pork, orange juice, sugar, natural gas and more. Additionally, futures contracts are also based on underlying securities, such as forex currencies, interest rates, bonds and equities.3
It is important to note that futures contracts are standardized. For the same underlying asset, the asset’s quantity (i.e., 10 tons of wheat), quality (i.e., wheat grades such as “U.S. No. 1”),4 delivery date (i.e., “June 1st, 2017”) and location (i.e., “New York City”) are standard.
Futures contracts are legally binding contracts. If a buyer has a forex futures contract to purchase 1,000,000 Japanese Yen at a forex rate of US$00.001 on September 1st, and that forex futures contract is not closed out by the delivery date – if it was sold to another buyer, or sold and replaced with another forex futures contract with a later delivery date – the buyer must then purchase the underlying commodity or asset at the agreed to price. Buyers rarely if ever actually take physical delivery of the underlying commodity, but instead purchase the rights, on paper, to take delivery of the asset or commodity. Conversely, if the seller of the forex futures contract is obligated to deliver those 1,000,000 Japanese Yen at a forex rate of US$00.001 by September 1st, and they do not close out their forex contract, they would be obligated to sell those 1,000,000 Japanese Yen to the other party in the forex futures contract.5
What Is An Option?
An option is a written agreement between two parties, which gives them the option to buy or sell an underlying commodity or asset at a specified price at a future date. While somewhat similar to a futures contract, an option grants the contracting parties the option to purchase or sell something. An option to sell the underlying asset is called a “Put Option.”
Essentially, the holder of the option has the right to decide to sell, or not sell, the asset on a specific date at a specific price, called the strike price. For example, ABC Company writes a forex put option to have the option to sell 1,000,000 Japanese Yen at a forex rate of US$00.001 on September 1st to the counterparty, XYZ Company. If ABC Company chooses to exercise its forex put option, on September 1st it will sell 1,000,000 Japanese Yen at a forex rate of US$00.001 to XYZ Company, and XYZ Company must purchase those 1,000,000 Japanese Yen at a forex rate of US$00.001; regardless of what the actual forex rate is for Japanese Yen versus US Dollar at that time. Conversely, if ABC Company had written a forex call option, for 1,000,000 Japanese Yen at a forex rate of US$00.001, with XYZ Company as the counterparty, then on September 1st ABC Company would have the option to demand that XYZ Company sell those 1,000,000 Japanese Yen at a forex rate of US$00.001 to ABC Company.6
Forex futures and options can offer useful advantages to manage forex cash flows, income, and obligations. They can also expose traders to risk. Using futures and options incorrectly can expose the trader or business to losses, if the underlying assets or commodities change value in unexpected ways.